Add news
March 2010
April 2010
May 2010June 2010July 2010
August 2010
September 2010October 2010
November 2010
December 2010
January 2011
February 2011March 2011April 2011May 2011June 2011July 2011August 2011September 2011October 2011November 2011December 2011January 2012February 2012March 2012April 2012May 2012June 2012July 2012August 2012September 2012October 2012November 2012December 2012January 2013February 2013March 2013April 2013May 2013June 2013July 2013August 2013September 2013October 2013November 2013December 2013January 2014February 2014March 2014April 2014May 2014June 2014July 2014August 2014September 2014October 2014November 2014December 2014January 2015February 2015March 2015April 2015May 2015June 2015July 2015August 2015September 2015October 2015November 2015December 2015January 2016February 2016March 2016April 2016May 2016June 2016July 2016August 2016September 2016October 2016November 2016December 2016January 2017February 2017March 2017April 2017May 2017June 2017July 2017August 2017September 2017October 2017November 2017December 2017January 2018February 2018March 2018April 2018May 2018June 2018July 2018August 2018September 2018October 2018November 2018December 2018January 2019February 2019March 2019April 2019May 2019June 2019July 2019August 2019September 2019October 2019November 2019December 2019January 2020February 2020March 2020April 2020May 2020June 2020July 2020
News Every Day |

How the stock market rally is feeding on itself

The emergence of brash retail traders who think stocks only go up has been one easy explanation for the surprisingly strong market recovery since March.
Some analysts, however, argue the rebound has more to do with the same technical factors that exacerbated the initial bear market — the rise of volatility-sensitive investors and the increasing influence of derivatives on financial markets.

“Positioning played a huge role in the extent of the sell-off, and has been a big part of the rally as well,” said Bankim Chadha, chief global strategist at Deutsche Bank.

Markets have long been characterised by “procyclical” forces that magnify peaks and troughs. Investors are naturally flightier at times of turmoil, and become more bullish as markets rise. But volatility is now embedded into virtually all risk management tools. When turbulence rises, traders are forced to ditch positions, and when it falls they get the green light to dive back in.

There has also been rapid growth in recent years in investment strategies that are even more closely tied to the level of volatility. These include trend-following hedge funds, risk parity funds that allocate to a wide array of assets weighted according to their volatility, and managed volatility products sold by insurance companies.

Low bond yields have also nurtured the growth of derivatives-based strategies, where investors look to secure extra streams of income by selling potential market gains through call options, or protect against calamities through put options. On the other side of these transactions are banks and other investors that want to generate returns by buying the upside or selling protection against falls.

“One of the lessons of the past decade is that long periods of low yields have a lot of side-effects, and this is one of the costliest,” said Luca Paolini, a strategist at Pictet Asset Management. “Financial engineering does nothing to help the economy long-term.”

hen markets are particularly choppy, rising volatility can force banks to hedge their exposure to these derivatives by selling their stocks in already falling markets. Many analysts say that the price swings in March were made more severe by volatility-sensitive funds ratcheting back their positions, and bank trading desks hedging their options exposures.

When volatility falls, however, the dynamics are reversed — which some say may be a factor in the strength and speed of the market recovery. The Vix index of equity-market volatility, sometimes called Wall Street’s “fear gauge”, has slumped from a high of over 80 in mid-March to about 32 this week, though it is still above its long-term average of about 20.

That reduction in turbulence has spurred trend-following hedge funds to cover short positions and buy stocks again, analysts note. Risk parity funds tend to move more slowly, but managed-volatility funds have added up to $20bn to their equity exposures in the past two weeks, after the longest stretch of daily increases in allocation since October 2019, according to Deutsche Bank.

A recent surge in options trading — driven in part by gung-ho day-traders — has also likely contributed to the rally. Goldman Sachs estimates that at about $5tn, the open interest of options is now about a fifth of the S&P 500’s overall market capitalisation, compared to an average of 14 per cent of the US benchmark index in 2013-2017.

Moreover, about 20 per cent of all S&P 500 options traded since the beginning of April have had a maturity of less than 24 hours, up from 3-5 per cent in 2011-16, according to Goldman Sachs.

This can have an impact on the actual equity market, akin to the tail wagging the dog. Options with a closer maturity are generally more sensitive to changes in prices. For example, when an investor buys a call option maturing the next day, the counterparty in the trade may be forced to buy the underlying stock to hedge its exposure as it rises closer to the strike price.

Not everyone is convinced that technical factors such as these have played a big role in the rapid revival since March. One volatility-focused hedge fund manager stressed that the effects of such factors tend to be greater when markets are tumbling.

However, Mr Chadha points out that stock market liquidity — a term used to describe how easily assets can be bought and sold — is still relatively low, so even modest increases in equity exposures can have an outsized impact on prices.

Given how many volatility-sensitive strategies still have small weightings in stocks, and are likely to ramp them up in coming weeks, he reckons the rally has further to run. “The risk is that the recovery is a lot stronger than people expect,” he said.

Read also

Banana Peels and EFCC’s diary of jinxed leadership

Issue 1342: China is the greatest threat (Digital Edition)

AMC Offers New Debt Agreement in Hopes of Surviving Coronavirus Shutdowns

News, articles, comments, with a minute-by-minute update, now on — latest news 24/7. You can add your news instantly now — here